Why we should be nervous about QE and inflation

I was an early advocate of quantitative easing, raising the possibility in September 2008 and advocating its commencement from November 2008. But, speaking as a fan of the idea, I have never been under any illusions regarding its difficulties, dangers, and limitations.

The purpose of doing quantitative easing was to prevent a crash in the quantity of money in the economy. The relevant sense of the "quantity of money" here is quite broad, including everything used to mediate transactions, including credit cards, bank transfers and so on as well as notes and coins. Everyone is familiar with the idea that if the quantity of money grows rapidly there is inflation. Well, if it contracts rapidly, there will be deflation. From late 2008, there was a considerable risk that the quantity of money would have contracted rapidly, because most of the money in a modern economy is created by the banking sector and if the banks are bust they stop creating money – indeed, the effort to get themselves out of being bust means they actually contract the amount of money.

Quantitative easing increases the quantity of money in the narrowest senses of the term "money" – it expands what is called the "monetary base" (it doesn't really matter for our purposes precisely what that is – just think of it as "the amount of notes and coins in circulation plus some technical stuff"). Now there is some relationship between the amount of monetary base and the total quantity of money – let's call it a "money multiplier". That money multiplier relationship depends on all kinds of things, such as how many working cashpoints there are in the country, how much people use credit cards, how easy it would be to get a loan quickly if you really needed it, and so on. In general, the bigger the money multiplier, the more extra total quantity of money we get by increasing the monetary base a given amount.

Over the medium term the key determinants of that money multiplier relationship (and hence how much total money there is for a given monetary base) are real fundamental factors that don't depend on day-to-day events in the economy. But in the short term the relationship can be heavily influenced by matters such as expectations for policy, fear of deflation-induced defaulting, and banking sector insolvency.

So if the banks go bust, what happens is that the money multiplier falls dramatically, so if the amount of monetary base doesn't change, there will be a tendency for the total quantity of money to contract. If we don't want the deflation that would follow (and hence the widespread defaulting on debts), we need some combination of curing the banking sector and providing additional monetary base to make up for the temporary collapse in the money multiplier. That was why I favoured QE.

But note: if the QE works or the banking sector returns to health (e.g. because the wider economy recovers), the result is that the more normal money multiplier will reassert itself. At that point the additional monetary base we created through QE will suddenly (perhaps very suddenly) start being multiplied up so the total quantity of money, far from falling, will suddenly start rising very rapidly and we will get inflation.

A few indicative numbers here might illustrate the problem. Let's suppose that we began with a money multiplier of 40 and a monetary base of £50 billion, so the total relevant money in circulation is £2 trillion. Then suppose our banks go bust, can create no new money of their own (so the money multiplier on new base money becomes 1) and the banks try to deleverage even their existing balance sheets so the money multiplier on existing monetary base falls to 35. Absent action, the total quantity of money would fall to £1.75 trillion and we could expect the price level to fall by perhaps 12.5 per cent (setting aside other complications). So to offset this, we might print an additional £250 billion, taking the monetary base to 300. Let's also assume that that crash was associated with some genuine change in the world, so that in the long-term the new equilibrium money multiplier is 35 (what the banks would have got to, if nature had been left to take its course).

OK. So initially, our QE policy seems to work quite well. We prevent the money supply crashing and prevent the deflation by printing £250 billion, sextupling the monetary base. And of course since the process is not increasing the quantity of money, but instead preventing it from falling, we don't get any inflation either. Folks say: "Ignore the QE panic-mongering: inflation isn't going up". Of course, they're right to do so – for now.

But think: what's going to happen later, if the policy works? Over the medium term, if the banks manage to get out of being bust, the money multiplier will be 35. So, if we leave it where it is, our new £300 billion of monetary base will become not £2 trillion of total money but £10.5 trillion, creating some 425 per cent of inflation.

I'm not predicting inflation will go to that level or anything remotely like it. Obviously the Bank of England will act to reduce the monetary base as the banking sector eventually heals itself. But how precise is it reasonable to believe the withdrawal of QE can possibly be, when the potential inflation arising from mistakes is so enormous, the downside risk of lapsing into deflation is so awful, and we have no historical precedent of any central bank achieving a smooth non-inflationary exit from such a policy? The great likelihood is that success for the QE policy and wider recovery in the economy will nearly inevitably be associated with a large burst of inflation and a good old-fashioned recession, as policy-makers have no option but to raise interest rates precipitously in response.